5 reasons the Fed isn’t troubled by inflation

Opinion: The 2% target could be breached soon, and Yellen wouldn’t care

WASHINGTON (MarketWatch) — For more than six years, the Federal Reserve’s harshest critics have been warning that inflation is about to get out of hand.

For more than six years, they’ve been wrong. Inflation has been well-behaved, despite very low interest rates and massive growth in the money supply.

Finally, it seems, the inflation hawks may have a point. In recent months, inflation has been accelerating, and the Fed’s 2% annual inflation target seems within sight. Inflation could blow right past 2%.

But is the Fed troubled that it might be falling behind the curve on inflation? Not in the slightest. Even noted inflation hawks like Richard Fisher, Charles Plosser or Esther George don’t expect inflation (as measured by the personal consumption expenditure price index) to breach the 2% target in 2016.

Here are five reasons the Fed hasn’t set its hair on fire about inflation:

As Fed Chairwoman Janet Yellen said in her press conference on Wednesday: “Recent readings on, for example, the [consumer price index] have been a bit on the high side, but … the data that we’re seeing is noisy.”

What she means is that the Fed won’t change its mind about where it thinks inflation is heading just because meat prices or gasoline prices spiked in May. Some prices are very volatile, and big increases in one period are often followed by large declines later.

It’s not that meat and gasoline prices don’t matter to people; it’s that the Fed can’t change its policy every time there’s an outbreak of porcine epidemic diarrhea virus that raises pork prices or a drought that culls the supply of beef.

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The public expects inflation to average only 1.83% over the next 10 years.

Expectations. At the Fed, the big question is: Where is inflation heading?

The future is always unknown, but the Fed takes great stock in the predictive power of inflationary expectations. The theory is simple: Before they sign on the dotted line, creditors, lenders, investors, bosses and employees all must have ideas about what the inflation rate will be over the relevant time period. The prices those people are willing to accept or to pay are informed by their inflation expectations; it becomes a self-fulfilling prophecy: Expected inflation becomes actual inflation.

So far, inflation expectations have been, in the Fed’s terminology, “well-anchored.”

There are many measures of inflation expectations that use various surveys and market data, such as yields on Treasury inflation-protected securities or consumer surveys. The best source is probably the Cleveland Fed, which combines TIPS, nominal bond yields and survey data to calculate a single expected inflation rate that’s been fairly accurate.

Currently, the public expects inflation to average 1.83% over the next 10 years, with little change over the past year. According to the expectations theory, inflation is going nowhere.

Housing. To help households repair their balance sheets and to fix the housing market, the Fed would like housing prices to rise, a little. And the Fed is getting its way: In the past year, home prices are up 10.3%, recovering some of the 34% decline between 2006 and 2012.

The rising cost of housing accounted for more than half of the acceleration in inflation over the past year, according to the Bureau of Labor Statistics. If shelter prices had been flat, the consumer price index would have risen only 1.2%, and no one would be talking about the threat of hyperinflation. But millions more families would still be underwater on their mortgage, and the housing market would be dead in the water.

Incomes. Along with housing, there is one other price that the Fed wishes were higher: the price of labor. Unfortunately, wages are not growing very fast. Over the past year, average wages are up just 2%, compared with a 2.1% increase in consumer prices. Real wages are down 0.1%.

Low wages are a strong sign that unemployment remains too high (prices soften when supply exceeds demand). Low wages are also a deflationary force, because they restrain consumer spending and keep the economy below its potential. Until wages start rising, the Fed won’t be satisfied.

Inflation isn’t being driven by strong demand. By law, the Fed is supposed to maintain stable prices. But that goal is constrained by the Fed’s tools.

The Fed can raise interest rates to choke off inflation caused by an overheated economy, but it can’t do much about inflation that’s caused by a supply shock, such as a spike in energy prices caused by geopolitical uncertainties, or a rise in food prices caused by a drought.

The problem in those cases isn’t too much demand from an overheated economy; it’s too little supply. And raising interest rates won’t produce more oil or make it rain.

The Fed can move demand up or down, but it can’t change supply.

Take a look at the main contributors to higher inflation over the past year: housing, fuels, medical-care services, meat and car insurance (those five items account for 78% of the rise in the CPI). Do any of those items indicate too much demand that needs to be throttled back? Or is the supply of those items constrained by geography, politics, weather or noncompetitive markets?

If inflation were being caused by too much demand, you’d see almost all prices rising. But that’s not what the data show. Prices are falling for all sorts of things, from new cars, washing machines and sofas to coffee, bread and peanut butter, from men’s suits and women’s shoes to jewelry and gin.

Finally, remember that the Fed’s main concern about inflation is not that it’s too high; it’s that it’s too low.

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